pro forma analysis

Pro Forma AnalysisPro Forma Analysis

Agribusiness FinanceAgribusiness FinanceLESE 306 Fall 2009LESE 306 Fall 2009

PASTPAST FUTUREFUTUREPRESENTPRESENT

Historical analysis

Comparative analysis

Historical price and yield trends

Pro forma analysis

Forming expectations about future prices, costs and productivity

Ad hoc extrapolations

Projections based upon available outlook data

Projections based upon econometric analysis

2009 2010 2011 2012 2013 2014 2015

Timeline Required for Timeline Required for Capital Budgeting…Capital Budgeting…

Assume it is the year 2009 and John Deere wants to project farm machinery and equipment sales over the next six years to determine if plant expansion is necessary.

2009 2010 2011 2012 2013 2014 2015

Timeline Required for Timeline Required for Capital Budgeting…Capital Budgeting…

Assume it is the year 2009 and John Deere wants to project farm machinery and equipment sales over the next six years to determine if plant expansion is necessary.

Capital budgeting models of investment decisions require projections of the annual revenue and cost values over the entire 2010 to 2015 time period.

Page 89 in bookletPage 89 in booklet

in bookletPage 74 in booklet

Remember the definition of annual net cash flowsRemember the definition of annual net cash flowsRemember the definition of annual net cash flowsRemember the definition of annual net cash flows


Must projectAnnual price

Must projectAnnual price

Must projectAnnual yield

Must projectAnnual yield

Alternative Forecasting Alternative Forecasting ApproachesApproaches

Ad Hoc Modeling ApproachesAd Hoc Modeling Approaches

?

Naïve model – using last year’s prices, costs and yields

Simple linear trend extrapolation of historical prices, costs and yields

Moving Olympic averageUsing assumptions

made by others

Naïve model:Pt = Pt-1

Linear trend:Pt = a0 + a1(Year)

Olympic average:Pt = Last 5 year annual price, dropping high and low and calculate the average of the remaining three year’s price.

Ad Hoc Modeling ApproachesAd Hoc Modeling Approaches

Econometric Model ApproachEconometric Model Approach

?Capturing future

supply/demand impacts on prices and unit costs

Linkages to commodity policy

Linkages to domestic economy

Linkages to the global economy

Concept of Derived Demand for Concept of Derived Demand for Farm MachineryFarm Machinery

The demand for farm machinery is driven by the expected net economic benefit from use of the machine….

Crop Market EquilibriumCrop Market Equilibrium

Quantity

Price

Pe

Qe

D S

Demand consists of:-Industrial use-Feed use-Exports-Ending stocks

Demand consists of:-Industrial use-Feed use-Exports-Ending stocks

Supply consists of:-Beginning stocks-Production-Imports

Supply consists of:-Beginning stocks-Production-Imports


Forecasting Future Commodity Price TrendsForecasting Future Commodity Price Trends

D

S

$4

10

$1

$7

D = a – bP + cYD + eXD = a – bP + cYD + eX

Ownprice

Ownprice

Disposableincome

Disposableincome

Otherfactors

Otherfactors


D

S

$4

10

$1

$7

S = n + mP – rC + sZS = n + mP – rC + sZ

Ownprice

Ownprice

Inputcosts

Inputcosts

Forecasting Future Commodity Price TrendsForecasting Future Commodity Price Trends

Otherfactors

Otherfactors


Projecting Commodity PriceProjecting Commodity Price

D = SD = S

D

S

$4

10

$1

$7

D = 10 – 6P + .3YD + 1.2XD = 10 – 6P + .3YD + 1.2X

S = 2 + 4P – .2C + 1.02ZS = 2 + 4P – .2C + 1.02Z

Substitute the demand and supplyequations into the the equilibriumcondition and solve for price

Substitute the demand and supplyequations into the the equilibriumcondition and solve for price Page 46 in bookletPage 46 in booklet

The Market ModelThe Market ModelDemand equationsDemand equations::Qd,i = a0 - a1(Price) + ai (demand shifters)

Supply equationSupply equation::Qs,i = b0 +b1(price) + bi (supply shifters)

Market equilibriumMarket equilibrium::ΣQd,i = ΣQs,i

An ExampleAn Example

Historical Data on Fixed Input Sales to FarmersHistorical Data on Fixed Input Sales to Farmers

Econometric Analysis Based on Time Trend ExtrapolationEconometric Analysis Based on Time Trend Extrapolation

It = f(Yeart)It = f(Yeart)

A linear time trend projection of future farm machinery and equipment sales therefore does a poor jobpoor job of predicting future sales activity.

A linear time trend projection of future farm machinery and equipment sales therefore does a poor jobpoor job of predicting future sales activity.

Econometric Analysis Based on Investment TheoryEconometric Analysis Based on Investment Theory

It = f{[E(Pt)×E(Qt)]/E(ct)}It = f{[E(Pt)×E(Qt)]/E(ct)}

Incorporates the economic concepts of MVP and MICIncorporates the economic concepts of MVP and MIC

An econometric model based on investment theory does a muchmuch better jobbetter job of predicting future sales activity.

An econometric model based on investment theory does a muchmuch better jobbetter job of predicting future sales activity.

Another ExampleAnother Example

Estimating the Annual Estimating the Annual Supply and Use of WheatSupply and Use of Wheat

Income elasticityIncome elasticity

Cross price elasticityCross price elasticity

Econometric Analysis – Food UseEconometric Analysis – Food Use

Own price elasticityOwn price elasticity

Observed and Predicted ValuesObserved and Predicted ValuesFor Wheat Food UseFor Wheat Food Use

Remaining Steps to Forecasting Remaining Steps to Forecasting the Price of Commoditythe Price of Commodity

Develop similar econometric equations for the other uses of wheat (feed use, exports and ending stock).

Develop econometric equations for production and import supply.

Substitute the estimated equations into the market equilibrium definition (Q(QDD=Q=QSS)) and solve for the price wheresolve for the price where excess excess demand equals zerodemand equals zero.

Stress Testing Your Stress Testing Your ForecastForecast

Point Forecast AssumptionsFarm

programpolicies

Macro-economicpolicies

Foreigntrade

policies

Globalmarketevents

Weatherand

disease

BaselineScenario

One scenario examined

What does this mean for: Crop and livestock prices? Unit input costs and farmland prices? Debt repayment capacity and credit risk? Asset valuation and collateral risk?

PE

QE

Assumes perfect

knowledge of outcomes in all

5 areas!!!!

Assumes perfect

knowledge of outcomes in all

5 areas!!!!

Point Forecast AssumptionsPoint Forecast Assumptions


Structural Pro Forma AnalysisFarm

programpolicies


Foreigntrade

policies

Globalmarketevents

Weatherand

disease

Scenario# 1

Scenario# 2

Scenario# 3

Scenario# 4

Scenario# 5

Scenario# 6

Scenario# 7

Scenario# 8

Scenario# 9

Multiple scenarios examined

D S

P

Q

Supply-side risk Supply-side risk for a given for a given

price…price…

Supply-side risk Supply-side risk for a given for a given

price…price…

QLQEQH

PE

Structural Pro Forma AnalysisStructural Pro Forma Analysis


Structural Pro Forma AnalysisFarm

programpolicies


Foreigntrade

policies

Globalmarketevents

Weatherand

disease

Scenario# 1

Scenario# 2

Scenario# 3

Scenario# 4

Scenario# 5

Scenario# 6

Scenario# 7

Scenario# 8

Scenario# 9

Multiple scenarios examined

D S

P

Q

Demand and supply-side risk and

potential price variability…

Demand and supply-side risk and

potential price variability…

QLQEQH

PH

PE

PL

Structural Pro Forma AnalysisStructural Pro Forma Analysis



A 48 percent chance that the price of wheat will be less than $4.16A 48 percent chance that the price of wheat will be less than $4.16


Potential Variability in Wheat Price 2008/09 MY GivenHistorical Variability in Growing Conditions Ratings

Triangular Probability DistributionTriangular Probability Distribution

$2.50 $3.00 $3.50$2.50 $3.00 $3.50


ConclusionsConclusionsEconometric models preferred over naïve

models and linear time trend models.Much more accurate.Provide much more information (e.g.,

elasticitieselasticities).Allow for sensitivity analysissensitivity analysis with

independent (exogenous) variables when evaluating potential variabilitypotential variability about expected trends.

NCF SummaryNCF Summary


G is the expected rate of appreciation


Allowing for unequal annual net cash flows….Allowing for unequal annual net cash flows….

in bookletPage 63 in bookletAllowing for unequal discount rates…Allowing for unequal discount rates…

Concept of Required Concept of Required Rate of ReturnRate of Return

Adjusting Discount RateAdjusting Discount Rate

We said to date that the discount rate is the firm’s opportunity rate of return.

Realistically we must allow for business risk by including a risk premium.

Realistically we must also allow for financial risk by adding an additional risk premium.

Business RiskBusiness RiskRisk associated with priceprice of the product or

products you are producing.Risk associated with the unit costsunit costs for the

inputs used in producing the product(s).Risk associated with yieldsyields (productivity) in

production.

NCFi=Piyieldsiunit sales – Ciunit inputs

Accounting for Business RiskAccounting for Business Risk

RFREE,i = risk free rate of return (i.e., govt. bond rate)RRRL,i = required rate of return for lowly risk averseRRRH,i = required rate of return for highly risk averse

RFREE,i

RRRL,i

RRRH,i

.05


Increasing Risk Over TimeIncreasing Risk Over Time

Expectedprice

Expectedprice

E(P)Year 1 Year 1 Year 10Year 10

Pessimisticprice

Pessimisticprice

Optimisticprice

Optimisticprice

Product pricedistribution


$2.95 $3.05 $3.15

Probability

Increasing Risk Over TimeIncreasing Risk Over Time

Expectedprice

Expectedprice

E(P)Year 1 Year 1 Year 10Year 10

Pessimisticprice

Pessimisticprice

Optimisticprice

Optimisticprice



$2.05 $2.95 $3.05 $3.15 $4.05

Probability

Financial RiskFinancial RiskRisk associated with low used borrowing

capacity (remember we captures this in the implicit cost of capital).

Risk associated with increasing explicit cost of debt capital relative to ROA. We discussed this when analyzing the economic growth model:

ROE = [(r – i)L + r](1 – tx)(1 – w)

Accounting for Financial RiskAccounting for Financial Risk

RFREE,i

RRRi

RRRi

.05


Required Rate of ReturnRequired Rate of Return

For the purposes of this course, we will measure the annual required rates of return based upon a subjective methods.

Ask yourself what additional return you require above a risk-free rate given your perceived annual business risk.

Ask yourself what additional return you require given existing leverage position.

RRRi = Rfree,i + Rbusiness,i + Rfinancial,i

One Strategy to Minimizing Risk ExposureOne Strategy to Minimizing Risk Exposure


Forecast horizon

NCFi

NCF with existing assetsNCF with existing assets

NCF with new assetsNCF with new assets

The Portfolio EffectThe Portfolio Effect

Forecast horizon

NCFi

Average annual NCF after making new investment.

Average annual NCF after making new investment.

The Portfolio EffectThe Portfolio Effect

This allows use to lower the business risk premium associated with the calculated the NPV for the new investment project. Exchanging stable profits for lowering exposure to risk.

This allows use to lower the business risk premium associated with the calculated the NPV for the new investment project. Exchanging stable profits for lowering exposure to risk.

Our Final NPV ModelOur Final NPV Model


Allowing for unequal annual net cash flows and required rates of return….

Allowing for unequal annual net cash flows and required rates of return….

NPV = NCF1[1/(1+R1)] + NCF2[1/(1+R1)(1+R2)] + … + NCFn[1/(1+R1)(1+R2)…(1+Rn)] + T[1/(1+R1)(1+R2)…(1+Rn)] – tx(T – C)[1/(1+R1)(1+R2)…(1+Rn)]

Our Complete NPV Capital Budgeting ModelOur Complete NPV Capital Budgeting Model

Discounted NCF in year 1

Discounted NCF in year 2

Discounted NCF in year n

Discounted terminal value

Discounted capital gains tax

NPV > 0 suggests project is economically feasibleNPV = 0 suggests indifferenceNPV < 0 suggests project is economically infeasible

Decision rule:

Ranking Ranking Investment Investment

OpportunitiesOpportunities


*

*

Borrowing PreparationBorrowing Preparation1. Up to date financial statements.2. Demonstrate trends in key financial ratios

including debt repayment coverage.3. Pro forma master budget before and after

proposed investment, including the line of credit or LOC.

4. Do sensitivity analysis.5. Demonstrate feasibility of investment plans by

using NPV capital budgeting using stress testing and incorporation of risk.

Both Sides of the DeskBoth Sides of the Desk

The borrower:•Enterprise analysis•Cash management•Line of credit needs•Operating loan application•Investment planning•Term loan application•Planning for long run

Coverage thus far this semesterCoverage thus far this semester

Both Sides of the DeskBoth Sides of the Desk

The borrower:•Enterprise analysis•Cash management•Line of credit needs•Operating loan application•Investment planning•Term loan application•Planning for long run

The lender:•Loan application analysis•Credit scoring•Loan pricing for risk•Loan approval process•Loan portfolio analysis•Loan loss reserves•Regulatory oversight•Lending institutions serving commercial agriculture and rural businesses.

After mid-term examAfter mid-term exam

pro forma analysis

Documents

future prices

future sales activity

equipment sales

years prices

year annual price

farm machinerythe demand

time trend extrapolationit

mican econometric model